Passive products need to be judged by the same standard as everything else
Last week’s public testimony on the Department of Labor (DOL) proposed fiduciary rule touched on a wide range of investment issues. One area that attracted little comment—but which is of particular interest to institutional investors—is the “low-fee exemption” that was floated for possible inclusion in the rule.
A low-fee exemption would create a conflict of interest
The DOL indicated in their commentary on the proposed new rule that they are considering an exemption for advisors who recommend low-fee products. They observe that some products have “fee structures in which the payments are sufficiently low that they do not present serious potential material conflicts of interest.”
I don’t think that the logic for such an exemption stands up. The exemption would create a safe harbor for advisors who recommend products that fall into the favored category (most of these products are likely to be passively-managed products.) That’s a material incentive for advisors to recommend these products. And when an advisor has an incentive based on their own interest rather than that of the client, that’s a conflict of interest. The conflict in this case is not based on direct monetary incentive, but on a legal incentive (i.e. exemption from the fiduciary rule), but it’s still a conflict of interest.
This is not just a hypothetical situation. Low-fee passive management solutions can be found in many corporate defined benefit (DB) and defined contribution (DC) plans. In the DB plan, any gains or losses accrue to the plan, and hence directly impact the sponsor’s costs. So it’s reasonable to assume that the DB plan reveals the sponsor’s best thinking on the question of how much passive management to use.
It might seem that the approach used for the DB plan should, then, generally be replicated in the DC plan. But that’s often not the case: DC plans in aggregate make considerably greater use of passive management than DB plans do. In practice, it’s easy to understand why: it’s a result of the incentive on the sponsor to minimize the risk of underperformance, and hence to reduce the risk of lawsuits. But note that the decision is not being driven by the best interest of the plan participants, rather by considerations focused on the fiduciary’s situation.
But who can argue against the greater use of passive investment?
There may remain a nagging suspicion for some, though, that even though this exemption would tilt the playing field, anything that encourages greater use of passive products is going to drive down fees and hence would be a good thing for plan participants. In other words: why should the DOL worry about creating a conflict of interest if the result of that conflict is an outcome that they see as desirable?
They should worry because although passive investment is generally cheap—and it’s often an appropriate route—it’s not always a good way to go.
Consider, for example, a broad market fixed income portfolio. The broadest market benchmarks run to many thousands of securities, many of which are illiquid, yet which tend to be concentrated in a few issuers from a few sectors. Weights in the index depend on how much debt an issuer has outstanding (which could potentially be a counter-indicator of the quality of the investment), not on the market’s collective assessment of the value of the company. Passive management eschews credit analysis, relying instead exclusively on ratings agencies’ assessments. Few corporate DB plans—even those who lean heavily on passive strategies in their equity portfolios—invest passively in fixed income. So broad market fixed income is an obvious counter-example to the assumption that passive can automatically be assumed to be a safe choice.
That’s why the idea of a low-fee exemption seems to us to be out of place in a regulation intended to make sure that each product is given fair and equal consideration, and to remove incentives from advisors that might bias their recommendations. The suitability of passive products needs to be judged using the same standards as for other products.
Access the full list of written testimony that has been submitted on the proposed rule (along with more than 2,600 public comments.)